Painfully Obvious Stock Tips

At The Motley Fool, we write for (and welcome!) all levels of investors. So whether you've been investing for five decades, five years, or just five minutes, you're equally welcome here.

Of course, that means some of the topics we write about are going to seem pretty elementary for some of our seasoned veterans. Newcomers to investing, on the other hand, may find that even our most basic insights into investing are revelations. Today, I'm going to tackle a topic that longtime Fools will find painfully obvious. But obvious or not, it needs to be repeated.

The yin and yang of averages
The financial media regularly mention "the average." The average stock does this. The S&P 500 does that. But think for a moment about what the average really means. It's a composite, made up of good companies and bad. Profit makers and money losers.

When we say that, on average, the stock market goes up 10% in value per year over long periods of time, we're speaking the truth. And it's the reason why we advocate investing your long-term savings in the common stocks of public companies, as opposed to buying bonds or depositing your cash in a passbook savings account. Over the long term, stock investing is simply the best way to grow your money, ensure your retirement, and create wealth to hand down to your children and grandchildren.

But remember, we're talking about averages here. If 10% is the average return from the stock market, that means that for every company that exceeds the mark, there's another that falls short. When that happens, to push the average back up to the, well, average, it takes a steady outperformer such as Coca-Cola (NYSE:KO) -- with a 30-year compound annual growth rate of 14.6% -- to come along and lend a hand.

You get the point. There are good and bad companies. Put 'em together and they create the average performance.

Ain't nothing wrong with being normal
Now, there's nothing wrong with being average. If you've got better things to do with your time than grow your money to the maximum extent possible, more power to you. You can do just fine as an investor. You can get by without ever having to read a balance sheet. You can be comfortable simply investing your savings in an S&P index fund. And you can put your money in there day in and day out and let it quietly grow until you retire.

Other investors, however, simply are not willing to settle for average returns. These investors know it's possible to do better than the average with a little bit of effort. At Motley Fool Stock Advisor, we aim to find and invest in only the "good" companies and to cut the losers whose dead weight drags all index funds -- and many mutual funds -- back down to the average.

If you think Wall Street is in Lake Wobegon, you're all wet
There's no such thing as a fund composed entirely of "above average" companies. Not in Garrison Keillor's fabled Minnesota town. Certainly not among the index funds. And not in actively managed mutual funds, either.

So we repeat: If you want to beat the average, you need to invest in the common stocks of individual companies. Avoid the bad. Pick only the good. Free yourself to rise above the mundane. But how, precisely, do you know which companies will perform better than the average?

Excellent question
And here's the answer: There's no guarantee. (Sorry, that's not what you wanted to hear, was it?)

But let me finish. There's no guarantee any company that appears to be a good investment will, in fact, succeed. During the past three years, many investors have looked at Dell (NASDAQ:DELL) as a can't-miss, sure-thing performer -- a stock that didn't know the meaning of "down." That was only until recently. The company as of late has been underwhelming Wall Street with its forecasts and growth. The stock has shed more than 30% of its value during the past 12 months.

If a fine company like Dell -- a company that has rewarded shareholders for more than a decade -- can take a multibillion-dollar hit with little to no warning, then there are certainly no guarantees in this business. Don't worry, there are ways to maximize your chances of success. One way is to seek out companies that produce better-than-average numbers. Literally.

Here's your cheat sheet
To determine if a company is producing better-than-average returns, you need to know what the average numbers are. (It sounds so logical, right?) Here's the latest data for the S&P 500 index, which is a good proxy for the overall market:

You can improve your investing "percentage" -- the likelihood that any given stock will exceed the average -- by comparing your prospects with the above list and investing in companies with one (or preferably more) superior metrics.

For example, right now the average S&P 500 company sports a return on equity (ROE) of 17%. It's priced at 17 times trailing-12-months earnings. It's expected to grow those earnings at just above 12%. (And for those of you punching away at your calculators, yes, the average company is therefore selling at a PEG of roughly 1.5, and so is, by traditional metrics, a tad overpriced.) Finally, the average company pays a historically tiny 1.7% dividend.

Let's compare those numbers to a few prospective investments among, for example, recently maligned energy stocks:

From a GAAP earnings standpoint, the chart teaches us that these energy firms seem to operate more efficiently than the average company. Their returns on equity are simply stellar.

Analysts also expect these companies to post below-average growth. Why? The answer is probably because there is no consensus about where energy prices will be next month, next year, or five years from now. As a result -- if you notice the price-to-earnings (P/E) ratios -- the market is not valuing these companies as if they are likely to achieve the same incredible level of revenue and income growth they have seen in the past few years. The common belief that energy is a cyclical industry prone to volatility and sudden downturns may also explain why these businesses -- three of which are superior based on ROE -- are all being bearishly valued the same. (If you believe differently, of course, this may be a buying opportunity.)

At Motley Fool Stock Advisor, we seek out only the best businesses for our subscribers -- companies that have superior ROE and low P/Es and the kind of consistent, healthy free cash flows that enable them to pay generous dividends, buy back stock, and grow their businesses. This strategy has served our members well. While the S&P 500 has gained 24% in value since the newsletter started four years ago, Stock Advisor picks are up by nearly three times that amount -- an average of 64%.

If you'd like to see how we do it, and take a look at some of the companies that have helped us rack up these market-beating returns, you're in luck. We're offering a free 30-day trial to Stock Advisor. Check it out and you'll receive unlimited access to our archive and research on every company we've recommended. There's no obligation to subscribe after your free trial expires, and if you're not absolutely thrilled with the service, you can cancel at any time.

This article was originally published on April 20, 2005. It has been updated.

Fool contributor Rich Smith owns stock in Dell, which is a Stock Advisor and Inside Value recommendation. Coca-Cola is a Motley Fool Inside Value recommendation. The Fool's disclosure policy is anything but average.